A limited constitutional government calls for a rules-based, freemarket monetary system, not the topsy-turvy fiat dollar that now exists under central banking. This issue of the Cato Journal examines the case for alternatives to central banking and the reforms needed to move toward free-market money.

The more widespread use of body cameras will make it easier for the American public to better understand how police officers do their jobs and under what circumstances they feel that it is necessary to resort to deadly force.

Americans are finally enjoying an improving economy after years of recession and slow growth. The unemployment rate is dropping, the economy is expanding, and public confidence is rising. Surely our economic crisis is behind us. Or is it? In Going for Broke: Deficits, Debt, and the Entitlement Crisis, Cato scholar Michael D. Tanner examines the growing national debt and its dire implications for our future and explains why a looming financial meltdown may be far worse than anyone expects.

The Cato Institute has released its 2014 Annual Report, which documents a dynamic year of growth and productivity. “Libertarianism is not just a framework for utopia,” Cato’s David Boaz writes in his book, The Libertarian Mind. “It is the indispensable framework for the future.” And as the new report demonstrates, the Cato Institute, thanks largely to the generosity of our Sponsors, is leading the charge to apply this framework across the policy spectrum.

Topic: Finance, Banking & Monetary Policy

Further to Ilya Shapiro’s post this morning, let me also point you to a concise chronology of events culminating in the government’s robbery of Chrysler creditors.

The story is that of Richard Mourdock, Treasurer of the State of Indiana and the man responsible for stewardship of the state’s pension funds, some of which were victimized by the Obama administration’s pre-packaged and then forced-fed bankruptcy deal for Chrysler. I strongly urge you to read Mr. Mourdock’s testimony, which is at once revealing, sobering, compelling and, regrettably, a frightening sign of the times.

In January 2009, Chrysler stood on the brink of insolvency. Purporting to act under the Emergency Economic Stabilization Act, the Treasury extended Chrysler a $4 billion loan using funds from the Troubled Asset Relief Program (TARP). Still in a bad financial situation, Chrysler initially proposed an out-of-court reorganization plan that would fully repay all of Chrysler’s secured debt. The Treasury rejected this proposal and instead insisted on a plan that would completely eradicate Chrysler’s secured debt, hinging billions of dollars in additional TARP funding on Chrysler’s acquiescence.

When Chrysler’s first lien lenders refused to waive their secured rights without full payment, the Treasury devised a scheme by which Chrysler, instead of reorganizing under a chapter 11 plan, would sell its assets free of all secured interests to a shell company, the New Chrysler. Chrysler was thus able to avoid the “absolute priority rule,” which provides that a court should not approve a bankruptcy plan unless it is “fair and equitable” to all classes of creditors.

Cato joined the Washington Legal Foundation, Allied Educational Foundation, and George Mason law professor Todd Zywicki on a brief supporting the creditors’ petition asking the Supreme Court to review the transaction’s validity. We argue that the forced reorganization amounted to the Treasury redistributing value from senior, secured creditors to debtors and junior, unsecured creditors.

The government should not be allowed, through its own self-dealing, to hand-pick certain creditors for favorable treatment at the expense of others who would otherwise enjoy first lien priority. Further, a lack of predictability and consistency with regard to creditors’ expectations in bankruptcy will result in a destabilization of existing and future credit markets.

The Court will be deciding whether to hear the case later this fall. Thanks very much to Cato legal associate Travis Cushman for his help with the brief.

Politicians and bank regulators across the world have come to the conclusion that excessive leverage, that is too much debt relative to equity, contributed to the depth of our recent financial crisis. Their solution: require banks to have more capital. If only it were so easy.

As Raghuram Rajan points out in a recent piece for the Financial Times, “banks will not be passive in the face of regulatory change.” Indeed, they will not. For instance, if you simply double a bank’s minimum required capital, the bank could respond by doubling the risk of loans on its portfolio. You move capital 8% to 16%, the bank can makes loans that default with expected losses at 16% and you haven’t done anything to reduce the risk in the system.

The problem with excessive leverage in our financial system was not that there was too much debt, but that debt-holders believed they would be bailed-out and hence provided little to no monitoring of bank activities. Reducing leverage does not increase the incentives of debt-holders to monitor, in fact it may reduce it, because debt-holders will now believe there is an even bigger cushion before they take any losses.

Why is it important for debt-holders to monitor the behavior of banks anyway? Because they are the largest piece of a bank’s capital structure. With an 8% equity stake, debt makes up 92% of the capital structure; with even a 16% equity stake, debt is still 84% of the capital structure. If there is no market discipline on debt-holders, then we essentially have no market discipline.

So how then to give debt-holders the appropriate incentives to monitor bank behavior? Quite simple, put them on the hook for losses. Rajan suggests we create “contingent capital” - debt that would convert to equity if capital levels fell below a certain level. While the devil is in the details, providing some system to impose losses on debt-holders is essential if we ever want to have functioning financial markets. Simply raising capital requirements does not solve that problem.

The Obama administration’s pay czar says negotiations over executive compensation with the seven companies that received the biggest federal bailouts have been “a consensual process’’ - not a matter of forcing decisions on them.

“I’m hoping I won’t be required to simply make a determination over company objections,’’ veteran Washington attorney Kenneth Feinberg told the Chicago Bar Association in a speech.

But note: he’s “hoping” he won’t have to impose his own view. He’s hoping the companies will accede to his power without complaining. But the fact remains, he doesn’t have to get their consent. He “has sole discretion to set compensation for the top 25 employees of each of those companies,” and his decisions “won’t be subject to appeal.” Or, as Feinberg himself puts it,

The statute provides these guideposts, but the statute ultimately says I have discretion to decide what it is that these people should make and that my determination will be final. The officials can’t run to the Secretary of Treasury. The officials can’t run to the court house or a local court. My decision is final on those individuals.

Despite the economic stimulus and various financial bailouts, our economy continues to shed jobs. One of the reasons for continued job losses is the decline in new hires, especially the lack of new hiring by small business.

As bank analyst Meredith Whitney discusses in the Wall Street Journal [$], all the major credit programs created by Congress and the Federal Reserve have been targeted at big corporations and Wall Street firms. However, small companies, especially start-ups and partnerships, do not issue bonds in the debt markets, nor do they borrow from Goldman Sachs. So these firms have been left out in the cold, as federal credit inventions have favored corporate America.

Adding insult to injury is that not only has Washington subsidized credit to large firms, it has taken actions that restrict the credit available to small firms and start-ups. The prime example of this is the Credit Card Reform Act signed by President Obama in May.

As Whitney reports, “Credit cards are the most common source of liquidity to small businesses, used by 82 percent as a vital portion of their overall funding.” In restricting the usage of credit cards and reducing the ability to risk-base price, Washington has eliminated the most important source of credit to small business.

Of course, being unable to project their future health care costs, or tax burdens (yes, they are going up, but by how much), many small businesses have either been forced to or chosen to sit on the sidelines of our economy. Washington needs to recognize that Wall Street and corporate American are not the sum of our economy, if we hope to turn the employment situation around.

The loss of 263,000 nonfarm jobs is another depressing economic statistic reinforcing the prospects of a jobless and joyless economic recovery. Job losses were widespread, but concentrated in construction, manufacturing, retail trade and government.

Employers want to fire, not hire. The reasons for this lie in Washington, where lawmakers are busy piling on spending, taxes, and mandates. From an employer’s perspective, each new hire is a liability. The Obama administration’s economic recovery plan, which was centered on job creation, is now a manifest failure. The stimulus brew it concocted has proven to be an economic depressant.

In an op-ed in today’s Wall Street Journal, Meredith Whitney highlights another serious economic drag on the economy: a continuing credit crunch. All the Obama Treasury and Fed lending programs have only served to direct credit to large companies, while small business — the engine of economic growth and job creation — has been starved of credit. The Treasury and Fed have a corporatist economic model, in which the favored few are benefited at the expense of the many. Their credit allocation policies have worked as a further drag on job creation.

This past week witnessed continued debate in congressional committees over changes to our financial regulatory system. Perhaps catching the most attention was Fed Chairman Ben Bernanke’s appearance before House Financial Services.

Sadly missing from all the noise this week was any discussion over reforming those entities at the center of the housing bubble and mortgage meltdown: Fannie Mae and Freddie Mac.

While many, including Bernanke, have identified the “global savings glut” as a prime force behind the historically low interest rates that drove the housing bubble, often missed in this analysis is the critical role played by Fannie and Freddie as channels of that savings glut. After all, the Chinese Central Bank was not plowing its reserves into Countrywide stock; it was putting hundreds of billions of its dollar reserves into Fannie and Freddie debt. Fannie and Freddie were the vehicle that carried excess world savings into the United States.

Had this massive flow of global capital been invested in productive activities, or even just prime mortgages, it is unlikely tha we would have seen such a large housing bubble. Instead, what did Fannie and Freddie do with its Chinese funds? It invested those funds in the subprime mortgage market. At the height of the bubble, Fannie and Freddie purchased over 40 percent of private-label subprime mortgage-backed securities. Fannie and Freddie also used those funds to lower the underwriting standards of the “prime” whole mortgages it purchased, turning much of the Alt-A and subprime market into what looked to the world like prime mortgages.

Given the massive leverage (at one point Freddie was leveraged 200 to 1) and shoddy credit quality of mortgages on their books, why were the Chinese and other investors so willing to trust their money to Fannie and Freddie? Because they were continually told by U.S. officials that their losses would be covered. At the end of the day, Fannie and Freddie were not bailed out in order to save our housing market; they were bailed out in order to protect the Chinese Central Bank from taking any losses on its Fannie/Freddie investments. Adding insult to injury is the fact that the Chinese accumulated these large dollar holdings in order to suppress the value of their currency, enabling Chinese products to be more competitive with American-made products.

While foreign investors have been willing to put considerable money into Wall Street, without the implied guarantees of Fannie and Freddie, trillions of dollars of global capital flows would not have been funneled into the U.S. subprime mortgage market. As Washington seems intent on continuing to mortgage America’s future to the Chinese, that at minimum it seems that fixing Fannie and Freddie might help insure that something more productive is done with that borrowing.